Question No 2

Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a $3.00 dividend per share (DPS) for the past several years, and its shareholders expect the dividend to remain constant for the next several years. The companys target capital structure is 60% equity and 40% debt, it has 1,000,000 shares of common equity outstanding, and its net income is $8 million. The company forecasts that it will require $10 million to fund all of its profitable (that is, positive NPV) projects for the upcoming year.

a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to fund its capital budget?

b. If Buena Terra follows the residual dividend model, what will be the companys dividend per share and payout ratio for the upcoming year?

c. If Buena Terra maintains its current $3.00 DPS for next year, how much retained earnings will be available for the firms capital budget?

d. Can the company maintain its current capital structure, maintain the $3.00 DPS, and maintain a $10 million capital budget without having to raise new common stock?

e. Suppose that Buena Terras management is firmly opposed to cutting the dividend; that is, it wants to maintain the $3.00 dividend for the next year. Also assume that the company was committed to funding all profitable projects and was willing to issue more debt (along with the available retained earnings) to help finance the companys capital budget. Assume that the resulting change in capital structure has a minimal effect on the companys composite cost of capital so that the capital budget remains at $10 million. What portion of this years capital budget would have to be financed with debt?

f. Suppose once again that Buena Terras management wants to maintain the $3.00 DPS. In addition, the company wants to maintain its target capital structure (60% equity and 40% debt) and maintain its $10 million capital budget. What is the minimum dollar amount of new common stock that the company would have to issue to meet each of its objectives?

Source: Brigham, E.F. and Houston, J.F., 2015. Fundamentals of financial management. Cengage